Making sense of high-frequency trading

AS THE sixth iteration of The Fast and the Furious franchise rolls out in cinemas, a greater speed demon lurks in our financial markets: high-frequency traders (HFTs).

While the good guys in Fast 6 are clear cut, academic researchers remain undecided on whether HFTs are heroes or villains of the market.

The fact that HFTs can even be deemed heroes may appear outrageous to the casual observer given the media regularly portrays them as villains.

Even some exchanges and market regulators have made up their mind on HFTs or are proposing ways to curb their activity. So what has academic research found so far?

What is high-frequency trading?

High-frequency trading is a nebulous phrase, though it is considered a subset of algorithmic trading (AT), which is the use of computer programs to trade on electronic exchanges.

High-frequency traders take algorithmic trading to the extreme and quickly trade in and out of financial instruments, sometimes only holding stock for a fraction of a second. Their profitability depends crucially upon both their speed in processing information and speed in trading, measured in milliseconds. Such behaviour led high-frequency trading to be branded as digital age pickpockets, as their pursuit of fast profits appears to allow them to get in and out of the market before others can click the buy or sell button.

These studies find that more algorithmic trading allows buyers and sellers to trade at more efficient prices. While the findings are on the broad algorithmic trading group, high-frequency traders appear to make up the majority of that group, with estimates at 73% for US trading.

Costs

Several papers however, argue that there are significant costs. For example, competition by HFTs may make markets worse, argues another paper also published in The Journal of Finance. They show that financial expertise improves a firms' ability to estimate value when trading a security.

Such financial expertise creates an unbalanced possession of information among the market participants, which, under normal circumstances, works to the advantage of the expert. This advantage is neutralised in equilibrium, however, by offsetting investments by competitors. Moreover, when market volatility increases, a market participant with expertise could take advantage of information superiority. This triggers breakdowns in liquidity, destroying gains to trade and thus the benefits that firms hope to gain through higher levels of expertise.

Even in well-functioning markets, HFTs may play a dysfunctional role, as modelled in a paper published in International Journal of Theoretical and Applied Finance. According to the paper, HFTs can create a mispricing that they unknowingly exploit to the disadvantage of ordinary investors. This contrasts with other participants who make financial markets more efficient by taking advantage of and thereby eliminating mispricing. This mispricing could be generated by the collective and independent actions of HFTs, coordinated via the observation of a common signal.

Neutral views

A couple of working papers provide differing neutral views on HFTs. Researchers at the University of Illinois argue that HFTs have no observed social benefit. They find that an arms race in speed at the sub-millisecond level is a positional game in which a trader's pay-off depends on her need for speed relative to other traders. However when HFTs profit due to speed advantages over other traders, the profit is offset by the technological costs required to gain such speeds.

Using detailed transactions data of four UK stocks that identifies trading participants including individual HFTs, researchers from the Bank of England find that HFTs may be good or bad depending on their trading strategy. They find that while some HFTs mostly consume liquidity and therefore are potentially disruptive, others mostly supply liquidity and therefore assist markets.

Researchers have just started delving into the world of HFTs. Ultimately the weight of such research will impact on the stance of exchange operators and market regulators and their decisions to throttle HFTs. While movie goers await the inevitable next iteration of The Fast and the Furious, high-frequency traders are anticipating their next instalment.